Indexing is great, but not perfect

I'm a huge fan of index funds. I think they should be the backbone of all investors' portfolios. Choosing index funds vs actively managed funds is an age old debate, and I'm not going to be the one to solve that debate.

Recently I got a little into the weeds of what indexing is and how it works, and some of the limitations. This is probably a good bit more in-depth than most people want to go on investing, but I had some light bulb moments that I thought were worth sharing. The Dimensional video series below does a really good job making it easy to understand.

The third video, Is the S&P 500 Index Passive? is the one I found most eye-opening.

https://www.dimensional.com/us-en/insights/how-dimensional-is-going-beyond-indexing

I had never even considered the decision of when to add a new company, or newly large company, to the Index. Or the requirements these Index fund providers have that are all different...based on whatever they decide!

I knew the indexes changed over time -- companies get bought/sold, merge frequently -- so I knew they had to make at least a few decisions around changes, but I never realized how impactful those decisions could be.

The Tesla example drives it home (ha!). The S&P 500 index funds missed a huge run-up because of the investment committee's profitability requirement. If you were simply in another more broadly-diversified large company index you would have captured this! And then for the investment committee to give a month heads-up on the reconstitution just seems silly, allowing many investors to front-run the trade.

This opened my eyes a bit. Indexes are still great and I won't be moving away from them, but I understand their limitations better now.